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1 posts from April 2013

April 30, 2013

Back before I started Alpha Theory, I was an analyst at a
hedge fund. I spent my days trying to find good ideas in which we could invest.
Along the way, I built a mini-checklist to speed up the process of evaluating
potential ideas. The checklist included mostly quantitative metrics that I
could build into a fancy spreadsheet like current PE compared to 10 Year
Average PE / High / Low, same for EV to EBITDA and Price to Sales, leverage
ratios, accounting ratios, insider holdings, short interest, etc. I could pull
this all together pretty quickly thanks to a combination of links from Bloomberg,
Capital IQ, and Factset and a few hours of manual due diligence.

With our quick checklist, we could plow through dozens of
names and eliminate those that didn’t qualify with speed. In a world where
positive expected return bets are few and far between, a streamlined evaluation
process increases your odds of finding more good bets. Of course, we ended up
doing customized analysis after it passed the initial test, but answering some
basic universal questions was step one.

I’ve spoken to hundreds of managers and I believe that most
funds have an implicit checklist (one that is understood but not formalized).
An analyst generally knows what questions the portfolio manager will ask and experience
leads them to ask many of the other important questions. However, after reading
the book, The Checklist Manifesto, by Atul
Gawande, I think it would be wise to make the fund’s implicit investment
checklists explicit. Alpha Theory is in the business of providing systems to
help managers make their decision process more objective by making it explicit.
But The Checklist Manifesto raises explicit
to a whole new level. The book begins by explaining the challenges of decision
making in complex systems. Complex systems are simply too grand, too
multivariate, for a human to comprehend their full scale. Because of this
complexity, we use heuristics (rules-of-thumb) to simplify the pieces into
understandable parts. These heuristics, while handy, can leave us with blind
spots. Gawande, who is a practicing surgeon, was tasked with trying to improve
surgical success for the World Health Organization. His answer, a checklist for
the nursing, surgical, and anesthetist teams to run through before and after
surgery. After a few iterations, the success was astonishing.

“The final results showed that the
rate of major complications for surgical patients in all eight hospitals fell
by 36 percent after introduction of the checklist. Deaths fell 47 percent.
Overall, in this group of nearly 4,000 patients, 435 would have been expected
to develop serious complications based on our earlier observation data. But
instead just 277 did. Using the checklist had spared more than 150 people from
harm— and 27 of them from death.” “More than 250 staff members— surgeons,
anesthesiologists, nurses, and others— filled out an anonymous survey after
three months of using the checklist. In the beginning, most had been skeptical.
But by the end, 80 percent reported that the checklist was easy to use, did not
take a long time to complete, and had improved the safety of care. And 78
percent actually observed the checklist to have prevented an error in the
operating room. Nonetheless, some skepticism persisted. After all, 20 percent
did not find it easy to use, thought it took too long, and felt it had not
improved the safety of care. Then we asked the staff one more question. “If you
were having an operation,” we asked, “would you want the checklist to be used?”
A full 93 percent said yes.” 1

These results are astonishing. If a drug or medical device
reduced death rates by 50%, it would be a blockbuster that every doctor
demanded. But even after these astounding results were published in the New
England Journal of Medicine, many doctors and hospitals were reluctant to
implement the checklist. Why? Perhaps inertia, dogma, ossification? Whatever
the reason, it seems to be common in most professions. The mentality suggests
“I’m sure it is important for others, but I don’t need it”.

Check in tomorrow for Part Two of “The Checklist: Evolution
of an Effective Decision Process.” We’ll find out what Dr. Gawande discovered
about money managers that use checklists.

1Gawande, Atul (2009-12-15). The Checklist Manifesto: How to Get Things Right. Picador.